Strategic Groups and a Firm’s Profitability

We have seen that differing strategic groups can have varying situations with respect to each and every competitive force acting on an industry. We are now in a position to answer the question posed earlier; namely, what factors determine the market power and hence profit potential of individual firms in an industry, and how do these factors relate to their strategic choices?

Building on the concepts already presented, the underlying de-terminants of a firm‘s profitability are as follows:


  1. Industry-wide elements of structure that determine the strength of the five competitive forces and that apply equally to all firms; these traits include such factors as the rate of growth of industry demand, overall potential for product differentiation, structure of supplier industries, aspects of technology, and so on, that set the overall context of compe-tition for all firms in the industry.


  1. The height of mobility barriers protecting the firm‘s strategic group.
  2. The bargaining power of the firm‘s strategic group with customers and suppliers.
  3. The vulnerability of the firm‘s strategic group to substitute products.
  4. The exposure of the firm‘s strategic group to rivalry from other groups.


  1. The degree of competition within the strategic group.
  2. The scale of the firm relative to others in its group.
  3. Costs of entry into the group.
  4. The ability of the firm to execute or implement its chosen strategy in an operational sense.

Industry-wide characteristics of market structure raise or lower profit potential for all firms in the industry, but not all strategies in the industry have equal profit potential. The higher the mobility bar-riers protecting the strategic group, the stronger the group’s bargain-ing position with suppliers and customers, the lower the group’s vul-nerability to substitute products, and the less exposed the group is to rivalry from other groups, the higher the average profit potential of firms in that group will be. Thus a second critical set of determinants of a firm‘s success is the position of its strategic group in the indus-try, which has been amplified in earlier sections.

The third category of determinants of a firm‘s position, which has not been discussed so far, is where the firm stands within its stra-tegic group. A number of factors are crucial to this standing. First, the degree of competition within the group is important because firms in the group may compete away potential profits among themselves. This effect is more likely to occur if there are many firms in the strategic group.

Second, all firms following the same strategy are not necessarily equally positioned from a structural standpoint. Specifically, a firm‘s structural position may be affected by its scale relative to others in its strategic group. If there are any economies of scale oper-ating that are large enough so that costs are still declining in the range of market shares held by firms in the group, then the firms that have relatively small shares will have lower profit potential. For example, although Ford and GM have relatively similar strategies and could be classified in the same strategic group, GM’s greater scale allows it to reap some of the economies inherent in the strategy that Ford cannot, such as in research and development and model changeover costs. Firms like Ford have overcome scale-related mo-bility barriers and gotten into the strategic group, but they still face some cost disadvantages relative to a larger firm in the group.

The firm‘s position in its strategic group also depends on its cost of entering the group. The skills and resources available to the firm in entering a group may give it an advantage or disadvantage relative to others in the group. Some of these skills or resources for entry are based on the firm‘s position in other industries or its previous suc-cess in other strategic groups in the same industry. For example, John Deere could get into almost any strategic group in the construc-tion equipment industry more cheaply than most firms because of its strong position in farm equipment. Or Procter and Gamble’s Char-min could enter the national brand toilet tissue group more cheaply because of the combination of Charmin’s past technological accom-plishments coupled with Procter and Gamble’s distribution strength. The costs of entry into a group can be affected by the firm’s timing of entry into it. In some industries it may be more expensive for late entrants into a strategic group to establish their position (e.g., higher cost of establishing an equivalent brand name; higher cost of finding good distribution channels because of foreclosure of channels by other firms). Or the situation may be reversed if newer entrants can purchase the latest equipment or use new technology. Differences in timing of entry may also translate into differences in cumulative experience and hence costs. Thus differences in timing of entry may translate into differences in sustainable profitability among members of the same strategic group.

The final factor entering into the analysis of a firm‘s position in its strategic group is its implementation ability. Not all firms pursu-ing the same strategy (thus in the same strategic group) will necessar-ily be equally profitable even if the other conditions that have been described are identical. Some firms are superior in their ability to or-ganize and manage operations, develop creative advertising themes with equal budgets, make technological breakthroughs with the same expenditures on R&D, and so on. These sorts of skills are not structural advantages of the sort created by mobility barriers and the other factors discussed above, but they may well be relatively stable advantages. The firms that have superior implementation ability will be more profitable than other firms in the strategic group.

This cascading array of factors jointly determine the profit prospects of the individual firm, and at the same time, its prospects for market share. The firm will be most profitable if it is in a favor-able industry, a favorable strategic group within that industry, and has a strong position in its group. New entrants do not eliminate the attractiveness of the industry because of entry barriers; the attrac-tiveness of a strategic group is preserved by mobility barriers. The strength of a firm‘s position in its group is the result of its history and the skills and resources available to it.

This analysis makes it clear that there are many different kinds of potentially profitable strategies. Successful strategies can be based on a wide variety of mobility barriers or approaches to dealing with the competitive forces. The three generic strategies described in Chapter 2 represent the broadest difference in approach; many vari-ations of these are possible. Much stress has recently been placed on cost position as the determinant of strategic position. Although cost is one approach to developing barriers, it should be clear that there are many others.

In view of the interacting nature of the considerations determin-ing firm profitability, the profit potential of a firm is strongly af-fected by the competitive outcome in those strategic groups that are market interdependent and have higher mobility barriers. The strate-gic groups with higher mobility barriers have greater profit potential than the less protected groups if competition within them is not too great. However, if competition within them is fierce for some reason and their prices and profits are thereby lowered, it can also destroy the profitability of the firms in the interdependent groups less protected by mobility barriers. Lower prices (or higher costs through advertising and other forms of non-price competition) spill over via market interdependence so that less protected groups must respond, driving down their own profits. This is a risk that must be assessed in choosing a strategic group.

A good example of this process is seen in the soft drink indus-try. If Coke and Pepsi get into a price war or advertising battle, their profits are diminished, but not nearly so much as those of the region-al and local brands who inevitably are affected because their produc-ers are competing for the same customers. Competition among Coke, Pepsi, and the other major brands, protected by substantial mobility barriers, lowers the profit umbrella over the regional and local brands. They tend to lose not only profits but relative share.


There has been much recent discussion about strategy arguing that the firm with the largest market share will be the most profit-able.6 The previous analysis suggests that whether this is true or not depends on the circumstances. If large firms in an industry compete in strategic groups that are more protected by mobility barriers than smaller firms, in stronger positions relative to customers and suppli-ers, more insulated from rivalry with other groups, and so on, then the large firms will indeed be more profitable than smaller firms. For example, in industries like brewing and the manufacture of toiletries and television sets, where there are substantial economies of scale in manufacturing, distributing, and servicing a full product line as well as economies of scale in national advertising, then the large firms in the industry will probably be more profitable than smaller firms. On the other hand, //economies of scale in production, distribution, or other functions are not too great, smaller firms following specialist strategies may be able to achieve higher product differentiation or greater technological progressiveness or superior service in their par-ticular product niches than larger firms. In such industries, smaller firms may well be more profitable than larger, broader-line firms (as in women’s clothing and carpets).

It is sometimes argued that if firms with small shares are more profitable than those with large shares, it reflects a mistake in indus-try definition. Proponents of the dominant role of market share ar-gue that we should define the market more narrowly, in which case “small” firms will indeed have a larger share of a specialized seg-ment than does a broad-line firm. But if we use a narrow market def-inition, we should also define the market narrowly in industries where broad-line firms happen to be the most profitable. In such cases we would often find that large firms did not necessarily have the highest share of every segment but yet reaped advantages of overall scale. Ascribing the higher profits of specialized, small-share firms to specialized market definition begs the question we are seek-ing to answer; namely, under what industry circumstances can a firm select a specialist strategy (to take just one strategic option) without being vulnerable to economies of scale or product differentiation achieved by broader-line firms? Or under what circumstances is overall share in the industry unimportant? The answer will differ by industry, depending on the array of mobility barriers and the other structural and firm-specific features that I have outlined.

Empirical evidence suggests that the relationship between the profitability of larger share and smaller share depends on the indus-try. Exhibit 7-1 compares the rate of return on equity of the largest firms accounting for at least 30 percent of industry sales (leaders) to the rate of return on equity of the medium-sized firms in the same in-dustry (followers). In this calculation small firms with assets less than $500,000 were excluded. Although some of the industries in the sample are overly broad, it is striking that followers were noticeably more profitable than leaders in 15 of 38 industries. The industries in which the followers’ rates of return were higher appear generally to be those where economies of scale are either not great or absent (clothing, footwear, pottery, meat products, carpets) and/or those that are highly segmented (optical, medical and ophthalmic goods, liquor, periodicals, carpets, and toys and sporting goods). The in-dustries in which leaders’ rates of return are higher seem to be gen-erally those with heavy advertising (soap; perfumes; soft drinks; grain mill products, i.e., cereal; cutlery) and/or research outlays and production economies of scale (radio and television, drugs, photo-graphic equipment). This outcome is as we would expect.


Another comparatively recent phenomenon in thinking on strat-egy formulation is that cost position is the only sustainable factor on which to build a competitive strategy. The firm with lowest costs, holds this view, will always be in a position to invade the territory of other areas of strategy, like differentiation, technology, or service, on which other strategic groups are based.

This view is seriously misleading, even putting aside the fact that low-cost position is by no means easy to sustain. As described most broadly in Chapter 2, in most industries there are a variety of ways to create mobility barriers or otherwise build a solid structural position. These different strategies will usually involve differing and often conflicting sets of functional policies. A firm attempting to achieve the greatest effectiveness at one strategy will rarely also be most effective in serving the needs met by others. Low-cost position within the strategic group may well be crucial, but low-cost position overall is not necessarily important or the only way to compete. Achieving low-cost position overall often involves a sacrifice in other areas of strategy, like differentiation, technology, or service, on which other strategic groups are based.

It is true, however, that strategic groups competing on bases other than low cost must be constantly aware of the differential be-tween their costs and those of the overall low-cost strategic groups. If this differential becomes large enough, then customers may be in-duced to switch to the lower-cost groups despite a sacrifice in quality, service, technological progressiveness, or other areas. Relative cost position among groups is a key strategic variable in this sense.

Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.

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